Richard Croft

Monday, July 24, 2006

I received so many e-mails from readers sharing their frustration on why you could not hold U.S. dollars inside an RRSP that I thought it was important to write a follow-up column.

As a refresher, readers might want to recall my column three weeks ago in which Mr. G., who manages his own affairs and deals with a discount brokerage firm, wanted to hold U.S. cash inside his RRSP brokerage account. His discount broker allows him to hold a U.S. money-market fund, but he cannot hold U.S. cash -- although his broker did promise a "wash rate" when converting from U.S. to Canadian currency and back again.

In my attempt to explain what a wash rate was, I noted that foreign currency is like any other security, in that there is a market with a bid and ask price. Those wanting to buy U.S. dollars would pay the offered price and those wanting to sell U.S. dollars would receive the bid price.

I noted off the top of my head that the bank might buy the U.S. dollars from you at a rate of about half a cent lower than what it would charge when selling them.

On that point, I received a number of e-mails suggesting that my spread example was not even close to reality, and that by using those numbers I "was doing a disservice to Canadian investors." For example, Mr. E. had bought and sold currency many times throughout the year, and suggested the bank was more likely to buy and sell using a spread of 3.6 cents. It was not my point to get into a debate about what the spread was, but to simply try to explain that a wash rate was somewhere between the normal spread.

What was interesting, however, was the number of readers who felt they were being ripped off by the conversion spread, to the point where it effectively eliminated the possibility of trading foreign securities inside RRSPs.

Remember, a registered retirement savings account is simply a Canadian-dollar denominated brokerage account. Like any brokerage account, you are assigned an account number.

With a non-registered (i.e. non-RRSP) account, you are typically assigned a Canadian and U.S. brokerage account with the same account number. In such cases, you hold U.S. cash and U.S. securities in the U.S. account and Canadian cash and Canadian securities in the Canadian account. Typically, no conversion takes place in either account.

But with RRSPs, you are required to have a Canadian dollar account, which means that everything you buy or sell in the account will always go through some conversion. In other words, when you buy a U.S. security, you must convert Canadian dollars into U.S. dollars, and then you can hold the security as an asset in the brokerage account.

However, when you sell the security, the U.S. dollars received from the sale will automatically be converted back into Canadian dollars, just as would happen if you purchased any security denominated in a foreign currency inside a Canadian dollar account. And there lies the problem. If you are losing 3% from the spread on every conversion, it makes it very difficult to trade foreign securities inside an RRSP.

One reader, Mr. J., thought that brokers could hold U.S. dollars inside an RRSP by simply setting up U.S. cash as a security. I'm not technically proficient with the back offices of Canadian based brokerage operations, but I would assume if it could be done and there was enough demand for it, one of the brokers would take up the challenge.

The problem for all of our readers is that at present, an RRSP cannot be an account denominated in a foreign currency. An RRSP account must be a Canadian dollar account, and any cash held in that account must be in Canadian dollars. What this does is force conversion into and out of Canadian dollars anytime you trade a security denominated in a foreign currency. And the cost of the conversion makes it almost impossible to earn any profit from foreign securities inside an RRSP.

At this point, the only solution is not to trade foreign securities inside an RRSP. If you are going to hold a foreign security inside your RRSP, hold it for the long term. That would typically lead you to a foreign-currency denominated exchange-traded fund or a good U.S.-dollar denominated mutual fund.

For some, there was an interest in holding U.S. dollars as a hedge against the Canadian dollar. If, for example, you thought the U.S. dollar was undervalued against the Canadian dollar. In a normal U.S. dollar account, you might buy short-term U.S. treasury bills. But inside your RRSP, that strategy would not work, because when the treasury bill matured, you would again go through the conversion process.

A U.S. money market fund, as I suggested in the previous column, might work, but if that fund distributed cash flow monthly that you wanted re-invested, that too, will go through a conversion process before it gets reinvested back into the fund. Again, back to square one.

What is most disturbing about this is how it caught so many investors off guard, and why none of this was explained to them before they embarked on their efforts to top up their foreign holdings because of the change in RRSP foreign content rules.

It appears, like our Mr. G., many other readers have discovered that our government has in effect given brokers the right to eat half my lunch, by allowing these foreign exchange conversion costs.

- Richard Croft is president of Croft Financial and is co-author of the best-selling Protect Your Nest Egg: Canadian Guide to Wealth Protection. Address portfolio questions to croftfin@aol.com.

He writes for the Financial Post on Mondays.